©2015 Morningstar, Inc. All rights reserved.

Christine Benz, Director of Personal Finance

Morningstar, Inc.

November 9, 2019

Six Retirement Blind Spots and How to Fix Them

2

g Why I’m passionate about simplifying retirement portfolio planning

g Key blind spots that retirees can miss as they create their plans, including:

/ Retirement date risk

/ Sequence-of-return risk

/ Low-yield risk

/ Inflation risk

/ Health care, long-term care risk

/ Longevity risk

g How retirees can mitigate those risks with portfolio and financial planning

Presentation Overview

3

Reason 1: People make investing more complicated than it ought to be. (“The Financial Complexity Complex.”)

Reason 2: Retirement decumulation is inherently MUCH more complicated than retirement accumulation.

Reason 3: Behavioral issues further “complexify” retirement planning and lead to behavioral traps—e.g., investing for current income, not total return.

Reason 4: Retirees are the ultimate “just-in-time” learners.

Reason 5: DIY investors need to protect their plans against the possibility of cognitive decline

5 Key Reasons Why I’m Passionate about Simplifying Retirement Portfolio Planning

4

Pre-Retirees: At What Age Do You Expect to Retire?

Retirees: At What Age Did You Retire?

Survey: NPR, The Robert Wood Johnson Foundation, Harvard School of Public Health

5

g Working longer isn’t always a possibility due to factors such as:

/ Unexpected job loss/difficulty replacing a job

/ Difficulty doing a job that entails physical exertion

/ Health issues: Own, spouse’s, parent’s

g Risks for the viability of a retiree’s income replacement following early retirement include:

/ No opportunity to make additional portfolio contributions

/ Fewer years for portfolio assets to compound prior to drawdown

/ Withdrawals over a time horizon that’s greater than 25-30 years have to be very modest (<4% of initial balance) to ensure a high probability of sustainability

/ May reduce ability to benefit from delayed Social Security filing (past full retirement age)

Retirement Date Risk: Why It Matters

6

g Nurture human capital over age 50 with additional training, staying current on technological developments, etc.

g Consider “backup” work plan in case of unplanned early retirement (“encore career”)

g Save more while working!

g Insurance planning

/ Health care if need to retire prior to age 65

/ Disability for self

/ Long-term care (esp. for married couples)

Retirement Date Risk: How to Mitigate It

7

Retirement Date Uncertainty Calls for a Higher Savings Rate While Working

Survey: David Blanchett, Journal of Financial Planning

8

A Tale of Two Retirements

9

g Sequencing risk refers to the order in which your investment returns occur

/ Ideal sequence of return risk: Poor returns in accumulation (buy low) followed by strong returns in early years of retirement (sell high)

/ Negative sequence of return risk: Strong returns in accumulation (buy high) followed by weak returns in early years of retirement (sell low)

g Negative return sequencing affects one of two things (or both):

/ Retiree reduces withdrawals/standard of living to reduce risk of running out of money later in life

/ Retiree doesn’t reduce withdrawals and runs out of money later in life

Sequence of Return Risk: Why It Matters

10

Could New Retirees Be Heading into a ‘Bad Sequence’?

Fairly High Valuations = Muted Returns for U.S Stocks and Bonds

11

Source: Morningstar Markets Observer

Outside Experts Largely Corroborate Morningstar’s Pessimism

BlackRock (June 2019)

➢ 6% nominal returns for U.S. large caps over next 10 years

➢ 2% returns for bonds

JP Morgan (October 2019)

➢ 5.6% nominal returns for U.S. stocks over next 10-15 years

➢ 3.4% nominal returns for U.S. investment grade corporates

Research Affiliates (November 2019)

➢ 0.5% real returns for U.S. large caps over next 10 years

➢ -0.6% real returns for Bloomberg Barclays Aggregate over next 10 years

12

13

g Two key levers to combat sequencing risk

/ Reduce portfolio withdrawals in weak market environments

– Employ a fixed (and low) withdrawal on an ongoing basis (e.g., 3%)

– Employ a “ratcheting” strategy to tie portfolio withdrawals into portfolio returns (Jonathan Guyton “guardrails” strategy)

/ Maintain enough in safer assets to ensure that withdrawals don’t come from falling/depreciated assets (“bucket approach”)

– Withdrawals won’t necessarily come from safe assets, but they can if stocks drop

Sequence of Return Risk: How to Mitigate It

14

Bucket Approach Provides Bulwark Against Sequencing Risk

Bucket 1

For: Years 1 and 2

Holds: Cash

Goal: Fund Near-Term Living Expenses

Bucket 2

For: Years 3-10

Holds: Bonds, Balanced Funds

Goal: Income production, stability, inflation protection, modest growth

Bucket 3

For: Years 11 and beyond

Holds: Stock

Goal: Growth

15

Bucket 1: Liquidity Portfolio for Years 1 and 2: $120,000

$120,000 in CDs, money market accounts/funds, other cash

Bucket 2: Intermediate Portfolio for Years 3-10: $480,000

$100,000 in Vanguard Short-Term Bond ETF BSV

$150,000 in Vanguard Short-Term Inflation-Protected Securities VTIP

$230,000 in iShares Core US Bond Market IUSB

Bucket 3: Growth Portfolio for Years 11 and Beyond: $900,000

$350,000 in Vanguard Dividend Appreciation VIG

$225,000 in Vanguard Total Stock Market Index VTI

$250,000 in Vanguard FTSE All-World ex-US VEU

$75,000 in Vanguard High-Yield Corporate VWEHX

Sample In-Retirement Bucket Portfolios: ETF

Retirees Spending $60,000/Year from Portfolio

16

Heard About the ‘War on Savers’?

17

g Many retirees aim to subsist on whatever income distributions their portfolios kick off

g When yields decline, income-centric retirees are left with one of two choices

/ Subsist on less income

/ Venture into higher-yielding/higher-risk bonds in search of a higher payout

– Longer-duration bonds– Lower-quality bonds

/ Bond yields have historically been a good predictor of bond returns over the next decade

/ Current long-term Treasury yield: 2.15% (October 8, 2019)

Very Low Yield Environment Risk: Why It Matters

18

‘Livable’ Yields Come at a Price

High-Yield Bonds Emerging Markets Bond

Current Yield: ~ 5%-7% Current Yield: ~6%-7%

2008 Return: -24% 2008 Return: -18%

Bank Loan Multisector Bond Fund

Current Yield: ~3%-4% Current Yield: ~3%-4%

2008 Return: -17% 2008 Return: -15%

19

g Rather than using income alone to supply living expenses, use:

/ Pure rebalancing to source needed cash flows/prune appreciated securities

– Pros: Most rational; rebalancing allows you to take risk out of the portfolio by selling appreciated components

– Cons: There won’t always be something to sell (maintain cash ‘bucket’ for lean periods)

/ Hybrid: Spend current income (but don’t stretch for it), use rebalancing cash flows to supply additional living expenses

– Pros: Appeals to retirees’ desire to have a baseline level of current income distributions

– Cons: Combination won’t always deliver needed cash flow; maintain liquid reserves in case

Negative Yield Environment Risk: How to Mitigate It

20

g Example of the opportunistic approach in action

/ Retiree needs $40,000 in cash flow from $1 million portfolio to re-fill bucket 1 in 2017

/ 60% S&P 500/40% bond portfolio yields $21,500 in 2017

/ Portfolio also has capital return of $118,680 in 2017

/ Retiree’s $40,000 cash flow distribution comes from:

– $21,500 in income– $19,500 from capital return – Retiree reinvests remaining $99,180 of capital return or

steers it to cash to cover next year’s living expenses

How Retirees Can Source Cash Flows without Stretching for Yield

21

g In 2018:

/ S&P 500 return: -4.38%

/ Bloomberg Barclays Aggregate Index return: 0.01%

/ Holding two years’ worth of portfolio withdrawals in cash helps guard against years in which neither stocks nor bonds provide rebalancing opportunities

/ Holding short-term bonds serves as next-line reserves in case cash is depleted and income insufficient/rebalancing opportunities aren’t there

But Some Years Won’t Be That Good

22

Inflation Is Benign…Or Is It?

Source: St. Louis Fed

Older Adults Spend More on Categories with Higher Inflation

CPI-E measures consumption for older adults; older adults spend differently than the general population.

Medical Care Inflation: A 3.42% Annual Rate Between 2000-2010

Higher spending on health-care tends to drive a higher inflation rate for older adults.

25

g Inflation is a factor for all of us, but it’s especially negative for retirees because:

/ The portion of their portfolios that they’re withdrawing is not automatically inflation-adjusted (in contrast with our paychecks and Social Security)

/ Inflation is the natural enemy of anything with a fixed payout:

– Nominal (non-inflation-adjusted) bonds– Fixed annuities

/ More conservative portfolios have lower return potential, so inflation takes a bigger bite in percentage terms

Inflation Risk: Why It Matters

26

g At the portfolio level, consider:

/ Treasury Inflation-Protected Securities, I-Bonds

/ Stocks: Best long-run shot at beating inflation

/ Niche categories: Bank-loans, high-yield, REITs (recognize interest-rate sensitivity)

g At the plan level, consider

/ Delaying Social Security: Enhanced return is also inflation-adjusted

/ Adding inflation protection if purchasing long-term care insurance, annuities

Inflation Risk: How to Mitigate It

27

Who’s Smiling Now?

Source: David Blanchett, Morningstar

28

Health Care Cost Risk: Why It Matters

g The average married couple will need $280,000 in aftertax dollars to cover their in-retirement health care costs, per Fidelity

g Retiree health-care costs include the following:

/ Medicare premiums (Part B, D)

/ Supplemental insurance policy premiums, copays, deductible

/ Pharmaceutical costs

g Remember: Those insurance costs are not brand-new; most retirees had them subtracted from their paychecks prior to retirement

29

Retirees’ Health-Care Costs Vary Widely Based on Health, Geography, Income

Source: Vanguard

30

Health Care Cost Risk: How to Mitigate It

g Portfolio plan should factor in possibility of higher health-care costs in retirement

/ Customize cost forecast factoring in any chronic health conditions, geography, income level

/ Factor in likelihood that health-care costs will increase later in life

g Portfolio plan should also factor in risk of high out-of-pocket costs in early retirement, pre-Medicare years

g Proper insurance is essential: Medicare Parts B and D, supplemental insurance policy

g During accumulation years, take advantage of tax-sheltered ways to save for health-care expenses, especially health savings accounts

31

A Closer Look at Health Savings Accounts (HSAs)

Source: HealthEquity.

32

Long-Term Care Cost Risk: Why It Matters

g Long-term care is non-medical care for people who are unable to complete activities of daily living (bathing, dressing, etc.)

g This type of care is not covered by Medicare (unless it happens to arise in connection with a qualifying hospital stay—”rehab”)

g An extended long-term care need can loot a portfolio

/ $102,200: Average nursing home cost, private room, 2019 (Genworth)

/ Costs vary dramatically by geography (Annual nursing home cost, private room, NYC: $161,148)

/ Women tend to require paid long-term care more often than men

/ Average length of stay: ~2.5 years

33

Long-Term Care Risk: How to Mitigate It (Real Headline: No Good Answers)

g Purchase insurance

/ Premiums have increased substantially over past decade

/ Many insurers out of the business altogether (125 insurers offering standalone LTC policies in 2000; 15 today)

g Purchase a hybrid long-term care/annuity or hybrid long-term care/life insurance policy

/ Policies have supplanted traditional long-term care insurance

/ However, more opaque, harder to comparison-shop

/ Don’t offer guarantees of higher payouts if yields increase in the future

g Self-fund using portfolio assets and/or home equity

g Rely on government resources

/ Can create risks for “well” spouse

/ Will limit care choices

34

This Is a Good News Story, Right?

35

Longevity Risk: Why It Matters

g 19 years: Average life expectancy: 65-year-old male

g 21 years: Average life expectancy, 65-year-old female

g 31%: Odds that one member of a 65-year-old couple will live to age 95

g Higher incomes correlated with longer life expectancies (better access to health care, access to better health care)

g Meanwhile, % of population with pensions (lifetime income) has declined

/ 67% unionized private sector workers covered by pensions (2013)

/ 78% of public sector workers covered

/ 13% of non-unionized private-sector workers covered

36

Longevity Risk: How to Mitigate It at the Portfolio Level

g To help ensure portfolio’s sustainability (and in turn, ability to deliver cash flow) over a very long life, consider:

/ Maintain a conservative withdrawal rate (<4% if time horizon is longer than 25-30 years)

/ Reinvest a portion of required minimum distributions if bulk of portfolio is in tax-deferred account

/ Hold healthy allocation (at least 50%) in stocks, diversified by style, size, geography

37

Longevity Risk: How to Mitigate It at the Plan Level

g Maximize non-portfolio sources of lifetime income, such as:

/ Social security maximization: Waiting longer not always the right answer, but can help enhance lifetime, survivors’ benefits

/ Pension maximization: Annuity option often the better bet for retirees concerned about

/ Annuities: To annuitize or not?

– Can be complex, costly, often sold, not bought

– Income annuities, immediate and deferred, tend to be less complicated, less expensive

– Quality longevity annuity contracts (QLACs) are also an option

38

Questions? Comments?

christine.benz@morningstar.com